European government bond yields may be very low for a long time, a likelihood that should prompt treasury executives considering those investments to take the plunge rather than stay in cash, according to a Prudential Financial report. Likewise, it might also be a good time to issue euro-denominated debt as well.
With the German Bund 10-year bond falling below 1 percent from more than 2 percent over the last year, and rates from bonds issued by some peripheral eurozone countries falling even further, investors may be wary about rates rebounding and principal taking a hit. Robert Tipp, chief investment strategist and head of global bonds at Prudential Financial, noted in a recently published report that inflation in the eurozone has decelerated, and some of the peripheral countries have actually slipped into mild deflation.
“This latest move lower in Euro rates, in some respects, is really shocking,” said Mr. Tipp in an interview. “Core European government bond yield curves pretty much across the maturity spectrum—from two years through 30 years—have basically dropped into the realm of Japanese government bond yields.”
Yields on Japanese government 10-year bonds have been around 2 percent or less since the late 1990s.
Mr. Tipp said the European economies may be a bit under-rated in terms of growth, but to return to stronger growth and target inflation will require rock-bottom government rates and significant quantitative easing-type accommodation from the European Central Bank (ECB). And other factors specific to Europe strongly suggest those rates may not rise for years.
Interest rates for US Treasurys, after all, have been low since the financial crisis, and the first round of quantitative easing (QE) started soon after, but the latter is only ending this month, and it’s still an open question whether the Federal Reserve will raise rates in 2015.
“So in Europe, where demographics are worse [than the US], and the economy is structurally less dynamic, the combination of sub-zero money market interest rates and other extraordinary ECB measures will presumably be the norm for at least a year or two, if not longer,” Mr. Tipp said.
If that’s the case, staying in cash would be a mistake, since the investor would be giving up significant yield, even at today’s low rates. Mr. Tipp explained that an Italian investor may see today’s 2.5 percent yield on Italian government bonds, down from more than 4 percent a year ago, and decide to wait for rates to rebound. But an investor that ends up waiting five years will have given up low double-digit income on that bond.
“At that point, it becomes a five-year bond, so the yield would have to rise by a couple of hundred basis points for you to lose in principal what you’ve gained on the income side,” Mr. Tipp said.
Low benchmark rates typically mean lower coupons on corporate bonds, and that’s not the only reason now for issuing sooner rather than later.
“Even if the drop in spreads continues, that may be accompanied by economic deterioration, which could drive spreads wider or damage market sentiment,” Mr. Tipp said. “So on the plus side, issuing when rates have dropped has the benefits of, one, taking advantage of low rates and, two, locking in long-term funding for defensive reasons.”
That would provide funds should the economic growth fall hard and access to the capital markets become impaired. Of course, paying a bond coupon while the money raised earns virtually nothing would result in a negative carry, or burn factor, while the issuer waits for opportunities to arise.
“In the end, the company may be glad it raised the money if either rates go up or the funding environment deteriorates,” Mr. Tipp said. “But in the meanwhile, there is a cost.”